US Financial Regulation

The new U.S. legislators have decided they will be the arbiters of what is an acceptable financial instrument. The movie industry cannot have a futures contract.

In the recent U.S. congressional hearings into the practices of Wall Street investment banks, the industry's interrogators were at pains to expose its apparent disregard for the impact of its activities on the broader community.

In the view of legislators, banks had come up with ever more opaque tools to boost their profitability at the expense of the clients in whose interests they should have been acting and the economy requiring their financial services to work effectively.

Somehow, there needed to be a social purpose test before a new product was permitted, according to many legislators in those hearings. They were warning that they could not be counted on to allow new products to proliferate as they had done in the past.

Just as these matters were being aired in Washington, broking firm Cantor Fitzgerald was putting the final touches to a new product: movie box office futures. It had reportedly spent tens of millions of dollars developing the idea and moving to establish a trading platform.

The product was intended as a hedging medium for movie production companies. Say a producer was unsure of the takings on the first weekend after a film's release. Or, let's say, a studio required a minimum gross revenue to fund a project. They could buy a contract, such as a put option, that gave them a return on their investments if ticket sales failed to reach a minimum value.

As always, such markets only work if there is someone willing to take the other side of the transaction. A box office contract might offer a chance for a range of institutional investors, pension funds and speculators to build portfolios exposed to some of the big name production houses. Portfolio constructors might have found a new instrument with a low correlation to other asset returns.

There could even be scope for research houses to review and rank the track records of producers so that investors could build portfolios based on the likelihood of productions being released successfully.

This would be entirely consistent with the type of financial instrument available to a whole range of industries from copper wire fabricators to wheat farmers and airline operators.

Unlike those longer standing futures contracts, a box office contract could gain a far wider audience. Whether or not retail investors were allowed to participate, the supermarket magazines would probably cover the price fluctuations in a way they would never have done in the past with a Chicago Board of Trade contract.

In June, the Commodity Futures Trading Commission approved the first futures contracts tied to box office receipts. The decision came from a regulator at the heart of the debate swirling around the causes of the global credit crisis. One would expect the commissioners to be among the most sensitive to concerns about the destabilizing effects of financial derivatives.

However, the commissioners were apparently not sensitive enough for post-2008 lawmakers. In the post-2008 Washington consensus, development of financial products has been taken out of the hands of financial institutions and must now be done with an eye to what is acceptable on Capitol Hill.

One complaint about a box office derivative product is that it differs from other products insofar as movie returns can be more easily manipulated than the returns in other markets. It might also create moral hazards. For example, if a producer or studio is able to lock in a return before release, they could become less concerned about whether the movie does well or not at the box office.

Strangely, the industry also argued, as it lobbied against the proposed new contracts, that its participants would be tempted to manipulate the data measuring box office receipts.

As telling as any technical argument was the vehement opposition of the Motion Picture Association of America. Notorious for flexing its political muscle to benefit the U.S. movie industry, it persuaded legislators to insert into the financial reform package passed by the Congress last week a ban on box office futures.

Whatever view one had about the social utility of box office futures, the ban opens up a new regulatory environment.

In vetting individual products, legislators have potentially removed certainty because, as with the proposed box office contract, they have banned a product that had already been approved by the designated regulatory agency.

The same legislators have also removed the freedom to innovate, at least within the jurisdiction of U.S. regulators. In doing so, incentives have been created for innovation to move elsewhere and perhaps to less well regulated business environments.

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